A complete guide to managing a diversified investment portfolio

A complete guide to managing a diversified investment portfolio

By Prashant Tandon

In the world of finance, there exists a nugget of wisdom that is often considered a universal truth: “Don’t put all your eggs in one basket.” This adage encapsulates the essence of diversification, a bedrock principle in almost all financial investment and wealth management strategies. Diversification is hailed as the key to mitigating risk and achieving long-term growth, serving as a shield against the unpredictable storms of the market.

However, the concept of diversification is not a panacea; rather, it requires thoughtful execution. Without context and insight, diversification can be a flawed concept, at best, and disastrous, at worst. Blindly spreading investments without considering the underlying dynamics of each asset class or market can lead to suboptimal results.

Context is paramount in effective diversification. Understanding the interplay between different asset classes, market cycles, and economic conditions is crucial for making informed decisions. For instance, during times of economic downturn, traditionally uncorrelated assets may become more correlated as panic selling ensues, challenging the conventional wisdom of diversification.

Global events, such as geopolitical tensions or systemic economic shocks, can also disrupt the assumed independence of assets. The correlation between traditionally uncorrelated assets, such as stocks, bonds, and real estate, spiked dramatically during the 2008 financial crisis.

According to data from the Chicago Board Options Exchange (CBOE), the correlation coefficient between the S&P 500 Index and the Barclays Capital U.S. Aggregate Bond Index reached unprecedented levels during the crisis, eroding the expected diversification benefits.

Also during 2008, S&P500 lost around 37%, NASDAQ Composite lost 40%, and NASDAQ 100 lost 41.89%. Even gold, generally considered a stable asset, registered significant fluctuations; having achieved a decade-long high at the end of first quarter in 2008, the asset class fell nearly 33% by the time of the collapse of the Lehmann Brothers.

Conversely, some of the most profitable investments during this time were strategically focused on just one or two asset classes; for instance, Dr Michael Burry’s Scion Capital had almost the entirety of its portfolio tied in short positions on US housing bonds which returned a staggering 489.34% from 2000-2008.

The COVID-19 pandemic, which began in 2019, had profound and widespread effects on global financial markets. Initially considered a health crisis, its economic ramifications were swift and severe. According to the International Monetary Fund (IMF), the global economy contracted by 3.5% in 2020, representing the steepest downturn since the Great Depression.

Diversification strategies again faced challenges as traditional safe-haven assets like gold and government bonds initially saw declines alongside riskier assets like stocks. The simultaneous sell-off across asset classes demonstrated the unique and unprecedented nature of the pandemic’s impact, underscoring that diversification alone may not shield portfolios from black swan events.

The surge in correlations among seemingly independent assets across the globe serves as a stark reminder that diversification must be approached with caution, and investors should be prepared to adapt their strategies based on the evolving dynamics of the financial landscape.

Diversification traditionally involves spreading investments across various assets, industries, and regions. However, taking it a step further by incorporating non-correlated strategies adds an extra layer of resilience to an investment portfolio. The essence of non-correlation lies in investments that have a low statistical relationship with traditional asset classes, such as stocks and bonds. These assets tend to move independently, or even counter-cyclically, to the broader market trends. In times of economic upheaval, non-correlated assets can act as a stabilizing force, offering a potential hedge against market downturns.

By incorporating non-correlated strategies into an investment portfolio, investors can enhance diversification and potentially reduce overall portfolio volatility. The key lies in carefully selecting strategies that respond differently to market conditions, thereby providing a more robust risk management framework.

The pursuit of non-correlated strategies and alternative investments is not merely about diversification for its own sake; it’s about seeking risk-adjusted returns. By incorporating assets that respond differently to market stimuli, investors aim to build portfolios that are not only diverse but also strategically positioned to weather diverse economic climates.

A few strategies used in creating a more robust portfolio may include long short strategies on fixed income and/or equities, life settlement funds, private debt and other alternative investment strategies. Of course, one needs high quality professional advise to access and implement these as a part of one’s investment portfolio.

In conclusion, while the adage “Don’t put all your eggs in one basket” remains a guiding principle, investors are increasingly recognizing the need to diversify beyond traditional boundaries. Non-correlated strategies and alternative investments offer a compelling avenue to not only mitigate risk but also potentially outperform traditional portfolios. As the financial landscape continues to evolve, the astute investor will navigate these uncharted waters with a keen understanding of the opportunities and challenges presented by this new frontier.

(Author is Managing director and CEO for Dubai, Lighthouse Canton)